Tax implications of different methods of business finance

For many businesses, initial setup costs are low for just an internet connection, smartphone, and laptop. Invariably, funding for expansion or the purchase of specific items will come from the owner’s resources or those of family or friends.

If an individual makes a gift either to a business owner or to the business itself, it is generally not considered as taxable income for the business. However, there are inheritance tax (IHT) implications for the individual, as gifts made by an individual can be subject to IHT if the donor passes away within seven years of making the gift. Where a director lends money to their company, the company may repay this amount without tax implications and interest can be paid on the loan.

The gift may be of an asset and, if the donor is a ‘partner’ company (i.e. a business entity collaborating with another to achieve mutual benefits, such as sharing resources), the recipient business is treated as acquiring the equipment at market value For the donor business, capital gains tax on the disposal may be payable.

The government provides non-repayable grants and subsidies but these come with specific eligibility criteria. Unless the funding relates to business-led innovation, such as research and development projects, the more likely application will be to Local Enterprise Partnerships, supporting businesses in specific regions. Most grants and subsidies are considered taxable income for the business, except those specifically exempted.

Other government funding is available via the Seed Enterprise Investment Scheme and Enterprise Investment Scheme but the conditions are restrictive, being aimed at companies rather than smaller individual start-ups. Incentives come in the form of income tax reductions, capital gains tax deferrals, and/or exemptions for the investor.

Should government funding or personal funding not be possible, the business will need to look at loans. Banks have certain criteria to be fulfilled before lending. Starting with smaller loans helps build a positive relationship with the bank and establishes a track record of repayment. Interest charged on any business loan or overdraft is tax deductible, with the capital amount being shown as a creditor on the balance sheet.

Alternative lenders and financing options including venture capital, angel investors, crowdfunding, or peer-to-peer lending may be possible. Venture capital and business angels refer to an individual or group willing to invest money in a new or growing business in exchange for an agreed share of the profits. Crowdfunding (also known as peer-to-peer lending) has tax implications if a ‘reward’ is expected in return for funding. For the business, the funds are considered taxable revenue. VAT may also apply if the rewards constitute taxable supplies. There are no tax implications for the donor, as the payment is made in exchange for goods or services, similar to a purchase.

Other financing

Assets purchased under a hire purchase agreement usually include an option to purchase at the end of an initial period. The expenditure is treated as being incurred as soon as the asset comes into use, even though not owned until the option is exercised. Finance charges are a business expense with the VAT payable with the initial installment (although not fully recoverable should the asset be a car).

A lease may be in the form of a short-funding finance lease or an operating lease – the difference is that the lessee cannot claim capital allowances on a finance lease as the lessor retains ownership. Payments are apportioned between the finance charge and the reduction of the outstanding liability, the finance charge being tax deductible with any VAT attached reclaimed on each payment.

Practical point

Gifts to a business can have varying tax implications, requiring careful consideration and accurate record-keeping. If a business borrows, it needs to ensure that the interest rates are manageable, comparing rates from different lenders. Equity funding may require surrendering ownership and control over the business – the TV program Dragons’ Den is an example.

Partner note:

IHTA 1984, ss. 3A, 94–102

ITA 2007, Part 5A

https://www.gov.uk/guidance/venture-capital-schemes-apply-to-use-the-seed-enterprise-investment-scheme#how-the-scheme-works

                                               For more information, Book a Free Consultation